The Cost of Business Cycles Under Endogenous Growth
50 Pages Posted: 14 Oct 2003
Date Written: August 2003
In his famous 1987 monograph, Robert Lucas argued that further stabilizing the business cycles that persisted in the post-War era was pointless, because these cycles had a negligible effect on societal well-being. In particular, Lucas demonstrated that society should be willing to pay only a tiny fraction of its consumption expenditures per year to completely eliminate the fluctuations that prevailed over this period. This conclusion has been largely reaffirmed by subsequent studies, and has been commonly cited as evidence that policymakers should abstain from intervening to offset macroeconomic fluctuations of the magnitude that prevailed over this period.
This paper disputes this conclusion and argues that the business cycles that prevailed over this period were costly, and thus opens the door to the possibility that stabilization policy might be desirable after all. It does this by demonstrating that business cycles can have a deleterious effect on the rate at which the economy grows over the long run. The reason is that cycles lead to volatile investment, reducing the efficiency of investment. Essentially, the fact that investment activity is concentrated in booms rather than spread out uniformly over time creates congestion effects that lower the productivity of investment. I estimate that eliminating the cyclical fluctuations that prevailed during the post-War period would have increased the growth rate of real GDP per capita in the U.S. from 2.0% per year to 2.5% per year. The cost of reduced growth from macroeconomic volatility is computed at a rate of 10% of consumption expenditures per year, over 100 times.
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